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April 29, 2010

Demagogues v. Goldman

Filed under: Finance — Steve Krupa @ 6:36 pm
Tags: , , , , , , , , ,

In 2008, Bear Stearns (founded 1923) and Lehman Brothers (founded 1850) were destroyed, after being in business for 85 and 158 years respectively, because they were not smart enough to reduce their long exposure to RMBS (Residential Mortgage Backed Securities) when there were clear signs of a potential market downturn.  Evidence, once again, that Wall Street plays a high stakes game where proper risk management is essential.   


Oddly, the Senate and the SEC have decided to make the best managed firm on Wall Street, Goldman Sachs, the focus of a witch hunt apparently designed to place Wall Street’s business activities front and center as the primary cause of the 2008 financial crisis (or what is now being referred to as the Great Recession).  The Demagogues (read: the Senate and SEC) seem determined to accuse Wall Street of fraud and unethical behavior designed to profit from a crashing housing and mortgage market.  It is a bold move, brilliantly timed in the midst of congressional debates around financial market regulatory reform.


Back on April 1, I got a little cheeky blogging about Matt Taibbi, the crazy-wonderful Rolling Stone journalist who is as passionate about vilifying Wall Street (and Goldman Sachs in particular) as Wall Street is about making money.  Matt’s claims of conspiracy are interesting (and funny).  On the serious side, I admitted concern over Wall Street’s political power, agreeing that Wall Street needed to take aggressive steps to reform itself, and expressing concern over whether unethical or criminal behavior might be discovered.


W/r/t unethical or criminal behavior, or lack there of, there is more accusing and not a lot of proving going on, especially if the SEC’s recent case against Goldman Sachs is representative of the best evidence gathered.  There is little doubt that Goldman Sachs pursued every possible angle to profit on a housing market run wild without demonstrating public concern regarding the systemic risk being created and its potential burden on society.  But is there any real evidence that they did anything unethical or illegal in the process?


The SEC thinks Goldman committed fraud in the issuance of a synthetic CDO (Collateralized Debt Obligation), called ABACUS AC-1, to ACA Capital and others in early 2007 because they did not disclose to investors the role of Paulson & Co. in the transaction (Paulson bought the short side of the deal and proposed several of the Reference Securities included in the CDO).    


Many in the Senate seem to think Goldman’s trading activities during the advent of the sub-prime mortgage crisis intentionally disadvantaged its clients, raising the specter of ethical violations, at a minimum.


I am not sure the SEC or the Senate can prove anything other than the inherent dog-eat-dog nature of financial trading, a little understood activity that for better or for worse is the bedrock of liquid markets and financial capitalism.


In the sales and trading business Goldman is not giving financial advice to its Clients, it is making a market in securities their Clients want to buy and/or sell.  That means they stand at the ready to provide a price at which they will execute a trade.  Goldman will attract Clients to their sales and trading business if they can be relied on to provide consistent pricing and liquidity.  The Clients, largely very aggressive and sophisticated financial institutions, recognize that Goldman may either be transacting for their own account or acting on behalf of a Client on the other side of the trade, and so it is accepted and known that Goldman is not financially aligned with their sales and trading Clients.  Further, Goldman’s Clients are trying to extract the best deal for themselves from Goldman in the trade.  These are big boys playing a high stakes game of I win and you lose.


So when a Client, like Paulson, comes to Goldman with interest in shorting (profiting from falling prices) RMBS, Goldman’s job is to find another Client interested in going long (profiting from rising prices) RMBS, put a deal together acceptable to both, and execute on the transaction by acting as its underwriter.  It seems to me that this is exactly what Goldman did w/r/t ABACUS AC-1.


Further, daily market making activities are inherently done with either a long or short bias depending on the condition of the trading book and the subjective preferences of the market maker.  Goldman clearly adopted a short trading bias near the advent of the sub-prime collapse, a business decision that seems to have contributed to saving the firm and its shareholder value (applause for the Goldman executives please), and an approach most other financial institutions (like the now dead Lehman) would have been wise to adopt at that time.  To argue that Goldman’s short bias acted against the interest of their Clients is as absurd as it is to suggest that Goldman should have purposely lost money on their trades.  Goldman’s Clients were clearly willing buyers and sellers and thought that they were getting the better of each of their trades with Goldman.  As with any trade, only one side will be right.


So I continue to wait for credible evidence that proves fraud, and given the weaknesses of both the SEC and Senate positions, I am doubtful it exists.  It seems I am left only with the opportunity to wince at the naked demagoguery.


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